At the time of writing, there’s a mix of anxiety, panic, and fear in financial markets as investors expect sudden increases in interest rates and inevitable declines in stock prices. Internet forums are flooded with people wondering what on earth the relationship between interest rates and stock prices is. Why should stock prices decrease when interest rates increase? Surely it should increase?!
Here’s everything you need to know to truly grasp this powerful relationship between interest rates and stock prices.
If you’re just wondering why stock prices and interest rates are inversely related (i.e., why stock prices drop when interest rates rise), here’s your answer:
Stock prices drop when interest rates rise because future cash flows are discounted at a higher rate than they were previously. This causes the intrinsic value / fundamental value of stocks to decrease. The market value of the stock follows suit swiftly.
Now, if that doesn’t make any sense, or if you’d like to better understand why this makes sense, keep reading.
Estimation of Stock Prices (And Their Relationship With Interest Rates)
To understand the relationship between interest rates and stock prices, it’s important to have a fundamental understanding of how stock prices are estimated.
If you understand this, then the rationale for why stock prices decrease when interest rates increase becomes as clear as day.
To be clear, we’re talking about the intrinsic value of a stock (what it should be worth).
We’re NOT referring to the market value of the stock.
That’s just whatever the price of the stock is in the stock market (which would be based on the intrinsic value if markets are efficient).
RELATED: What is Market Capitalization?
Stock Price Formula (Intrinsic Value)
The intrinsic value of a stock is estimated like this:
We’ll explain the different variables we’re working with in just a bit.
For now, let’s simplify this equation so we can make our lives a little easier.
If we make some simplifying assumptions about the stock’s future prospects, then we can simplify the equation for the intrinsic value of a stock even further, to this:
That’s all it is. One number () divided by another number ().
Now, we’re trying to keep the math pretty simple here, so we’re not going to go into the details of how we go from the first equation to the second one.
And we’re not going to dive into the “simplifying assumptions” either.
Yes, this does mean you need to trust our word.
But if you’re skeptical, that’s fine (and actually encouraged)! Check out the math behind the formulas in these three related articles:
- How to Calculate Stock Price (including 4 main approaches)
- Formula for Stock Valuation (essentially the equation above, but with a full walkthrough)
- Present Value of a Perpetuity (the underlying rationale behind the “simplifying assumptions” we made)
For this particular article, we’re just going to work with the most simplistic formula for the stock price, as:
Components of the formula for stock price
In this formula, we have three things including:
- which refers to the intrinsic price of the stock,
- which refers to some “future cash flows” generated by the stock on a per-share basis, and
- which is this thing called the discount rate
Let’s now consider each of these three things.
The Stock Price
reflects the intrinsic price of the stock (aka its “fair value”).
It’s what the price of the stock should trade at in financial markets (but it may not).
It reflects the fundamental value of the stock. And more generally, with a minor tweak, it can represent the fundamental value of the business, too.
The Future Cash Flows
The numerator, i.e., reflects the money we expect the stock to earn in the future.
This can three main forms, including:
- Free Cash Flow
- Free Cash Flow to Equity (aka “Flow to Equity”)
The simplifying assumption of this particular formula is that the firm earns the same cash flow every single year.
So, for instance, let’s say we assume that Apple Inc. just earns $500 billion in cash flows every single year, forever. Assume there are 100 million shares outstanding for Apple Inc. This would mean that we expect Apple Inc. to earn $5,000 in cash flow for every single share outstanding, forever.
Is it realistic? No.
Representative of the real world? No.
But that’s not the point here. We can complicate the model as much as we like, and make it far more realistic.
For now, all we’re trying to do is to understand the relationship between interest rates and stock prices.
And for that, our simplistic model/formula is more than enough.
The principles we’ll see in this simplistic model apply just as strongly in more ‘complex’ models, too.
Thus, the key takeaway for is that it reflects the future cash flows that the business is expected to earn.
The Discount Rate
Finally, we have that beautiful little thing , the “discount rate”, aka:
- Cost of capital
- Opportunity cost of capital
- Hurdle rate
- Interest rate (seeing the hint/connection now?)
This discount rate reflects the risk of the firm. Or put differently, it reflects the risk of the firm not earning the future cash flows .
And it is this precise “thing” – the discount rate – which causes stock prices to decrease when interest rates increase.
So let’s think about the discount rate in more detail.
Calculating The Discount Rate (And How Interest Rates Affect It)
We have a whole other article on how to calculate discount rate so if you’d like to get into the proper details, do give that a read.
One of the most common ways of calculating the discount rate is by using a model called the CAPM (Capital Asset Pricing Model).
If we use that model, then we can calculate the discount rate as…
Ignore and for now.
Let’s just focus on (the left-hand side) and (on the right-hand side).
here denotes the risk-free rate.
You can think of the risk-free rate as the aggregate interest rate (). It’s not quite the same thing, strictly speaking. But it’s pretty close to it.
And if we’re looking to understand the relationship between interest rates and stock prices, then it really does help if we just think of the risk-free rate as identical to the aggregate/national interest rate.
Now, what happens if increases and everything else on the right-hand side of the equation above remains unchanged?
Well, of course, the value for will increase!
Let’s try it out just for clarity. Assume that for simplicity.
The equation for the discount rate is equal to…
Plugging in the numbers, we’d have…
This now simplifies to…
If (the interest rate) increases, then (the discount rate) will also increase. And vice-versa.
The bottom line…
The discount rate increases as interest rates increase (and vice-versa).
Makes sense? Good. If not, please re-read the article up to this point.
Because the next bit assumes you understand everything we’ve covered so far.
We can now finally explore and answer the question on your mind…
Why Do Stocks Drop When Interest Rates Rise?
Stocks – strictly, stock prices – drop when interest rates rise because future cash flows are discounted at a higher rate than they were previously.
To see how this works, let’s see how a stock is actually priced.
Recall that the intrinsic value of a stock – in its simplest form – is calculated as:
Further recall that reflects the discount rate (aka interest rate).
When interest rates rise, so does the value for (the discount rate). See the subsection on “Calculating the Discount Rate” above to learn how this works.
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Mathematically, we now have a larger denominator for the same numerator, as a result of a higher interest rate.
This means the fraction as a whole will be smaller.
Thus, the value of – the stock price – will decrease.
Markets and investors then react to the new intrinsic value by selling shares or shorting stocks.
This results in negative stock returns and poor stock market performance in the short term.
RELATED: How to Calculate Stock Returns
Note that, naturally, the reverse is also true. If interest rates decrease, then stock prices will increase.
Investors would then buy more stocks, which will result in positive stock returns and stronger stock market performance in the short run.
In a nutshell, stock prices and interest rates maintain an inverse relationship such that:
- As interest rates rise, stock prices fall
- As interest rates fall, stock prices rise
Revisiting The Formal Expression of the Stock Price
Now, some of you may well be wondering – okay, this makes sense in the simplified form of the stock price. But what about the actual/complicated form?
Does the inverse relationship between interest rates and stock prices still hold?
Yes. Yes, it does.
Here’s that formal/full expression of the stock price formula again:
If the math is freaking you out, check out our financial math course now. You’ll finally get that mathematical foundation you know you’ve needed!
If you’re at least somewhat okay with the math, then notice the fraction after the summation function:
We still have the discount rate in the denominator.
Thus, an increase in interest rates (which would lead to an increase in the discount rate) will naturally cause a decrease in the fraction overall.
And this will result in lower stock prices (assuming everything else is constant, of course).
The relationship between interest rates and stock prices is inverse/negative.
Stock prices will decrease when interest rates increase. Unless there are “irrational” factors in place. We’ll touch on these further down.
For now, let’s think about what drives interest rate hikes.
Why Could Interest Rates Rise?
Interest rates could rise if governments and/or central banks wish to tackle inflation.
You might want to read this short article on why the Fed cares about tackling inflation.
Just FYI, “Fed” is short for the Federal Reserve, which is the Central Bank in the US.
The UK equivalent is the Bank of England. For India, it’s the Reserve Bank of India.
Each country will have its own central bank, which may or may not be completely independent of the government.
Indeed, the independence of a central bank from the government can make/break attempts to tackle inflation. But that’s for a whole other article!
Long story short, if the inflation rate is high, then:
- prices of goods (and services) increase
- households get hit by higher costs
- savings decrease thanks to greater spending
If governments or central banks want to reduce inflation, they can increase interest rates. As a result:
- saving becomes more attractive (given a higher interest rate)
- borrowing becomes less attractive (again, given a higher interest rate)
- households figure out ways to save more
- businesses (we hope) reduce prices to stimulate demand
- a new ‘equilibrium’ is reached, everyone’s happy, the risk of hyperinflation is mitigated
Note that this is a gross simplification. Financial economists and folks from Financial Economics reading this may well be cringing – we get it.
But it keeps things fairly simple, and the gist of the whole thing is maintained.
Do Central Banks React to the Stock Market?
Now that you know the relationship between stock prices and interest rates and how stock prices decrease as interest rates increase, perhaps you’re wondering if interest rates change based on stock market performance?
Put differently, do central banks react to the stock market?
In all likelihood, yes.
Because the stock market can be thought of as a representation of the economy as a whole.
Rising stock prices can be a signal of economic growth, for instance.
If stock prices are excessively high, however – far greater than fundamentals – then one might argue that the whole economy is in a bubble.
In such instances, it’s possible that there’s gross inefficiency and large wastage of resources and capital.
Central banks may attempt to counter these adverse effects by increasing interest rates.
Equally, if the stock market is deep in the red – i.e. if it’s a bear market vs. a bull market – and central banks want to tackle investor sentiment, they might lower interest rates.
Recall that the negative relationship between interest rates and stock prices means that if interest rates decrease, stock prices will increase.
Thus, the monetary policy of central banks can be impacted by the stock market. It’s not always the case that stock markets react to monetary policy. The reverse also applies.
If you’d like to explore this side of the coin in more detail, then Rigobon and Sack’s (2003) paper is a great start.
How Will A Low Interest Rate Environment Impact Your Portfolio?
As of the early 2020s, ‘Western’ economies, and the world in general, are seeing some of the lowest interest rates in decades.
But central banks in many countries are increasing their interest rates to tackle inflation.
The fundamentals will still hold for the most part, however.
This means that if interest rates rise, your portfolio of stocks will almost certainly be negatively affected.
A portfolio of bonds, on the other hand, could actually benefit from an interest rate hike.
That’s mainly because bond yields increase as interest rates increase.
Note that bond prices themselves will, of course, decrease if interest rates increase.
Bonds are a whole other ballgame so we’re going to leave it at that for now. But we’ve linked to a sister article on how bonds work, so if you’re interested in learning more, do give that a read.
RELATED: How Do Bonds Work?
If you’re like most investors, then it’s likely you have greater exposure to equities/stocks vis-a-vis bonds.
This naturally means you’re more exposed to the negative effects of interest rate hikes.
If you’re exposed to real estate (e.g., your personal home or even investment properties), then you’ll likely be adversely affected by interest rate hikes, too.
Mortgage rates will increase when interest rates rise, thereby increasing the cost of your mortgage.
Why Do Stocks Rise When Interest Rates Rise?
Okay, so we’ve spent the bulk of this article demonstrating that the relationship between interest rates and stock prices is a negative/inverse one.
Yet, the empirical evidence can sometimes show that stock prices increase as interest rates increase.
This is less to do with the equity market reacting to interest rates and is more likely to be the result of investor sentiment driving price increases.
Stocks rising with increases in interest rates is likely a time of high volatility in equity markets, too.
RELATED: Why Are Equities Volatile?
As far as the core economic fundamentals go, however, stock prices cannot rise when interest rates rise.
That is, of course, speaking purely from a mathematical and “intrinsic value” standpoint.
Investor sentiment and irrationality can lead to results that really do question the financial mathematics of securities!
In the long run, however, you can be pretty confident that equity markets will conform to the core evergreen fundamentals.
The short-run can be much more chaotic though!
Alright, hopefully, all of this makes sense. And you now know and fully understand the relationship between interest rates and stock prices.
The key takeaway of this article is that interest rates and stock prices maintain an inverse relationship.
As a result of this inverse relationship, stock prices decrease when interest rates increase.
Put differently, stock prices drop when interest rates rise because future cash flows are discounted at a higher rate than they were previously. This causes the intrinsic value / fundamental value of stocks to decrease. The market value of the stock follows suit swiftly.
Okay, that’s a wrap from us for this particular article.
If you’d like to broaden your understanding of financial markets and investing, do check out our rigorous courses on investing.
Keep learning, keep growing!